ECON 100 Lecture 3 Monday, February 11

Announcements The CASE Dean’s Office (Professor İnsan Tunalı) increased the section sizes from 90 to 110 students. (This is NOT my decision.) M-W 11:00 section created a small crisis (capacity kept at 90; waiting list erased) e-mail from the Registrar’s Office (received on Friday 11:38 A.M.) Kota artışları için fakülteden gelen isim listesi olan dersleri add/drop sonrası ekleyerek yapacağız. Econ 100 lec 4 ün eklenme listesi var. Bu yüzden öğrenciler şimdi silindi ama sonra eklenecek.

More announcements I will email you the time and place for all three problem sessions. They are optional and will be conducted like office hours as extra help for students. The first problem set will be posted on course webpage later this week. Course webpage http://ais.ku.edu.tr/course/20066/Default.html Last week’s lecture notes and participation records are posted.

of last week’s lectures A very brief summary of last week’s lectures

Economists assume that… people are rational — they have well-defined goals and try to achieve their goals as best as they can with available resources and information. More specifically, rational people behave according the following rule: “Take an action if, and only if, the benefits from taking the action are at least as great as the costs.” Do activity x if B(x) ≥ C(x)

The Cost-Benefit Principle Measuring the costs and benefits of an action is not always very easy. Stem-cell research Missile defense system Career choice Auto purchase

What are the problems? People sometimes ignore costs that should be counted, mostly implicit costs. Opportunity cost People sometimes count costs that should be ignored. Sunk cost More on this second “problem” later in the lecture.

Do not ignore the opportunity costs Making a rational decision requires the recognition of opportunity cost. Opportunity cost of an action is the value of the next-best alternative that we must give up in order to engage in that action.

Remember the Clapton vs. Dylan question from Wednesday’s lecture

The Opportunity Cost question You won a free ticket to see an Eric Clapton concert (which has no resale value). Bob Dylan is performing on the same night and is your next-best alternative activity. Tickets to see Dylan cost $40. You would be willing to pay up to $50 to see Dylan. There are no other costs of seeing either performer. Based on this information, what is the opportunity cost of seeing Eric Clapton? A. $0 B. $10 C. $40 D. $50

The correct answer is… B. $10

Why is B. $10 the correct answer? When you go to the Clapton concert, you give up the $50 of benefits you could get from the Dylan concert. But the Dylan concert costs $40 (ticket price). The value (net benefit) of the Dylan concert is $10. This is what you give up if you go to the Clapton concert. The opportunity cost of the Clapton concert is $10 the net benefit of the second best alternative.

This comes from a research paper by with the unusually long title Paul Ferraro and Laura Taylor, with the unusually long title “Do Economists Recognize an Opportunity Cost When They See One? A Dismal Performance from the Dismal Science.” It was also featured in the New York Times The Dismal Science, Dismally Taught - New York Times www.nytimes.com/2007/08/12/business/yourmoney/12view.html

They asked this very same question, which is taken from page 4 of Robert Frank and Ben Bernanke’s textbook, Introduction to Microeconomics, to PhD students and economics professors at the most important and largest economics conference, the ASSA meeting, in 2005. ASSA: Allied Social Science Associations meeting organized by the American Economic Association

How did the PhD students and professors answer this question? http://www2.gsu.edu/~wwwcec/docs/ferrarotaylorbep.pdf Respondents spent, on average, close to five minutes answering the survey. $0 25.1% $10 21.6% $40 25.6% $50 27.6%

How did Econ100 students do? Much much better

Our results $0 4 6,8% 8 10,5% $10 41 69,5% 62 81,6% $40 12 20,3% 3 3,9% $50 2 3,4%

Results (Spring 2012) $0 0% 1 2% $10 39 87% 46 81% $40 2 4% $50 5 11% 0% 1 2% $10 39 87% 46 81% $40 2 4% $50 5 11% 8 14%

Robert Frank, on teaching “principles of economics” “Equipped with thousand-plus page encyclopedic texts, many instructors feel they must acquaint students with every economic idea that has ever been written about. The unfortunate result is that, when the dust settles, most students leave these courses never having fully grasped the essence of the subject. 

Cont., For example, the opportunity cost concept, so central to our understanding of what it means to think like an economist, is but one among hundreds of concepts that go by in a blur. Opportunity cost is more important than, say, the idea that the short-run average cost curve is tangent to the long-run average cost curve at the output level for which capacity is at the optimal level. But one would never realize that from the relative emphasis these topics receive in many first-year courses.” -- Robert H. Frank

A difficult opportunity cost question You won a free ticket to see an Eric Clapton concert (which you can sell for $35, that means the resale value is $35). Bob Dylan is performing on the same night and is your next-best alternative activity. Tickets to see Dylan cost $40. You would be willing to pay up to $50 to see Dylan. There are no other costs of seeing either performer. Based on this information, what is the minimum amount (in dollars) you would have to value seeing Eric Clapton for you to choose his concert? Give a short explaination.

Super Difficult Question You have just purchased a new Corolla for 50.000 but the most you would get for it if sold it privately is 45.000 lira. Now you learn that VW is offering its Golf, which normally sells for 55.000, at a special sale price of 50.000 lira. If you had known before buying the Corolla that you could get the Golf at the same price, you would have definitely chosen the Golf. As a rational person what will you do: Keep your Corolla, or sell it and buy the Golf?

The scarcity principle The opportunity cost (fırsat maliyeti)

There is no such thing as a free lunch! Although we have boundless needs and wants the resources available to us are limited. As a consequence, having more of one good necessarily means having less of another. Consider the following statement “The citizens of Sweden are lucky because they have free health care while the citizens of the US have to pay for it.”

Our very first economic model The production possibilities frontier (PPF) Üretim İmkanları Eğrisi

Economic Models Economists use models to simplify reality in order to improve our understanding of the world. In constructing their models economists make (a lot of simplifying) assumptions in order to make the world easier to understand. One of the most basic economic models is The Production Possibilities Frontier

The scarcity principle means that people face trade offs. How many goods do we need (minimum)? Two Imagine a country that produces only two goods

Cars vs. Computers  Quantity of Computers Produced 3,000  D C 2,200 3,000  D C 2,200 600 A 700 2,000 Production possibilities frontier 1,000 300 B  1,000 Quantity of Cars Produced

Cars vs. Computers Quantity of Producing under the PPF (like at point B) means that the economy is not producing efficiently. Points outside the PPF (like D) are not attainable given the current endowment of resources and technology Computers Produced 3,000  D C 2,200 600 A 700 2,000 Production possibilities frontier 1,000 300 B  1,000 Quantity of Cars Produced

The Production Possibility Frontier is... a graph that shows the combinations of goods (and services) that the economy can possibly produce given the available resources and the available production technology.

Finally, let’s go back to Sweden vs. the US healthcare question “Citizens of Sweden are lucky because they have free health care while the citizens of the US have to pay for it.”

Sweden vs. the US (healthcare) Cars US A B Sweden Healthcare

Measuring the costs and benefits of an action is not always very easy!

People sometimes count costs that should be ignored. Sunk costs

Example: Sunk costs A group has arranged a bus trip to Niagara Falls. The driver’s fee is $100, the bus rental is $500 and the fuel costs $75. The driver’s fee is not refundable, but the bus rental may be canceled a week in advance but there is a cancellation fee of $100. At $25 a ticket, how many people must buy tickets a week before so that canceling the trip is definitely a bad idea?

Suppose that 20 people bought tickets. Should we cancel the trip or not? We have to make a decision because this is the last day for cancelling without paying the full amount of the bus rental.

Should we go or cancel? Compare costs and benefits Benefit = number of tickets soldx$25 What is the cost of this trip? Driver’s fee $100 + the bus rental $500 + fuel costs $75 = $675 If we have sold $675/$25 = 27 tickets, benefits > costs  go. Sunk cost : driver’s fee + cancellation fee = $200 Ignore $200 Relevant costs are $475 If we have sold $475/$25 = 19 tickets, benefits > costs  go.

Failure to Ignore Sunk Costs Sunk cost: A cost that is beyond recovery at the moment a decision must be made. Sometimes people are influenced by sunk costs when they should be ignored. This is the reverse of ignoring opportunity costs.

Sunk Costs Sunk costs are borne whether or not an action is taken. It is an expenditure that you cannot recover Therefore, they are irrelevant to a decision on whether to take an action.

People respond to incentives and Rational people think at the margin Next lecture: People respond to incentives and Rational people think at the margin